F5 Networks Looks to the Clouds for Growth

Mark Cash
Equity Analyst

Narrow-moat F5 Networks reported 2% year-over-year revenue growth to $545 million in the quarter, which was below our expectations, but we welcome the 30% annual increase in software sales as ADC consumption habits shift from on-premises appliances to software-based solutions. Operating margin of 26.2% came in below our forecast and was 40 basis points below the previous year's results as F5 ramped up hiring for sales and research and development (an approximately 5% increase in head count sequentially). Compared with the prior year, products revenue was flat at $238 million as the increase in software sales, with strength in public-cloud delivered offerings, offset the 5% year-over-year decline in system sales. Services revenue increased 4% year over year to $307 million. Although systems revenue decline and dips in operating margin could seem alarming, we believe F5 is deploying its resources appropriately to match the cloud-centric expectations of its customers and we are maintaining our fair value estimate of $181 per share and we believe this security provides an investment opportunity.

In our view, the increased operational costs are setting F5 up for growth in a cloud-centric selling environment. We believe F5 can capitalize on enterprises requiring software to deploy and manage workloads securely across multiple clouds and on-premises, while 5G and NFV can catalyze the service provider segment, and the Nginx acquisition opens the developer market side of applications. For next quarter, management guided a revenue range of $550 million-$560 million and a non-GAAP EPS range of $2.54-$2.57. Guidance does not include any impact from the Nginx acquisition that is expected to close in the second calendar quarter of 2019. We expect the top line to be achieved through continued software strength, tempered system sales declines, and service growth; also, we posit F5 can achieve the bottom-line target while ramping up development costs.

Business Strategy and Outlook 2019/03/08

F5 Networks, the leader in application delivery controllers (ADCs), sells to enterprises, service providers, and government entities. More than half of F5's revenue comes from selling support and maintenance services for its products. Mission-critical ADCs manage the uptime and delivery of applications and network traffic flow. ADCs were traditionally purchased as hardware that sits between firewalls and servers to mitigate traffic flow issues related to server failures. Growth in public cloud-based workloads caused a decline in the on-premises ADC hardware required and shifted ADC demand to software-based solutions. In our view, F5 was slow to embrace cloud-based workloads as it perilously defended its incumbent offerings, but a revamped management team properly pivoted F5's focus toward software and cloud-based products as growth catalysts to supplement its legacy hardware dominance, and we think the firm is set to thrive.

With 90% of its development team dedicated to software, F5's roadmap is focused on virtual instances of ADCs, standalone application security products, and products and services for multi-cloud application control. IT teams may rely on the large public cloud vendors for traffic management within their respective clouds, but F5 helps control the traffic between on-premises, private, and public clouds. With about 40% share of the ADC market, F5 will likely remain the go-to provider of solutions for their customers' cloud ecosystems due to product familiarity, customization features, application and network level management, security-focus, and an active developer community.

We opine that the expected data proliferation generated by Internet of Things and 5G devices will be a boon to F5. The complexity of managing application traffic will increase as disparate devices spread beyond the data center while requiring lower latency, larger data workloads, and protection from a growing quantity of security threat vectors, in our view. We posit that F5's consolidated approach for application and networking traffic flow across the entire network will remain in strong demand as businesses expand their creation and consumption of applications and data.


We assign F5 Networks a narrow economic moat. In our view, F5's switching costs are associated with the mission critical aspects of ensuring applications are properly deployed, secure, and optimized for network traffic flow. Additionally, we believe intangible assets are a secondary moat source, which is seen in F5's strong reputation, pricing premium, and design expertise. We expect a continuation of F5's stellar track record of producing excess economic returns over its invested capital in excess of its cost of capital for at least the next decade.

At the end of 2018, revenue streams were split as about 65% from enterprises, 20% from service providers, and 15% from the government sector. Services are more than 55% of sales, and the remaining revenue comes from product sales. For the last five years, gross margins have remained in the low-80% range and operating margins in the high-20% range.

In the late 1990s, F5's initial load-balancing appliances became a critical aspect of managing server workloads within data centers. Its products ensured that network traffic was balanced between servers and would redirect traffic from servers with issues. In the 2000s, the usage of applications to run and develop software programs and manage data workloads exploded within enterprises and F5 segued its portfolio to become the leader in application delivery controllers (ADCs). ADCs ensure that applications function at an optimal level and accelerate application delivery, in addition to processing the load-balancing functions for network traffic. Over time, ADCs added more complex features like web application firewalls, global traffic management, and analytics. We estimate, through Gartner and F5 data, that F5 controlled around 40%-50% of the ADC market in 2018. Enterprises IT networks are reliant on these products for optimal application and network traffic flow, and we believe switching vendors would be tremendously disruptive.

IT teams are utilizing more applications and software through public clouds and software-as-a-service vendors, which potentially means lower ADC hardware sales due to less networking traffic and application management needing to occur on-premises. Staying alongside this shift in networking and having over 90% of its product development team focused on software, F5's strategic focus pivoted toward software-based ADCs, multi-cloud application solutions delivered as cloud-based software, offering F5-as-a-service, and virtual editions of its products. F5's Silverline is a managed security platform that gives customers the ability to route their traffic through F5's hardware all the time or as needed, and we believe this is attractive to IT teams desiring professional security services in a flexible consumption model. In our view, as customers migrate more applications and workloads from on-premises there is value in staying with F5's software solutions over swapping vendors or implementing a multi-vendor approach. F5's operating system is considered best in class and changing software solutions would be a painstaking task, in our view. From a partnership side, we believe the hyperscale cloud vendors find value in collaborating with F5 due to its strong brand presence and engineering aptitude, which drives increased traffic flow to their respective clouds. We opine that IT teams have morphed their networks alongside F5's product releases to stay ahead of the latest traffic technology for applications, data centers, and multi-cloud environments.

F5's customizable approach to software provides enterprises flexibility to create the best solution for their networks. The iRules feature set allows customers to tailor traffic flow per their unique situations, and we believe this customer-centric approach helps keep F5 products engrained within networks. F5's DevCentral, an online community of developers and network architects, had over 350,000 registered members at the end of 2018. This collaborative environment allows individuals to share best ideas and request product enhancements. In our view, this online community is not a network moat source; however, we do believe this is an attractive feature to stay with the F5 ecosystem. We note that F5 has rolled out new features into its products through user developments in DevCentral, and we believe this community is ancillary to F5's switching costs and intangible assets moat sources.

Fair Value and Profit Drivers 2019/04/25

We are maintaining our fair value estimate of $181 per share for F5. This fair value estimate is equivalent to an enterprise value/adjusted EBITDA of 14 times and free cash flow yield of 6%. Our expectation is for a five-year revenue CAGR of 5% as sales ramp up from 3.4% growth rate in fiscal 2018. We expect software and cloud-based product sales to more than offset potential declines in ADC hardware sales. In our view, customers migrating to multi-cloud environments can become a tailwind for F5 as the proliferation of dispersed applications and data will require sophisticated traffic management and security solutions across the entire network ecosystem. We believe revenue from F5's shift toward selling more software, virtual systems, and cloud-based solutions will result in products outpacing services over our explicit forecast period. In our view, services may decrease toward 54% of sales in fiscal 2023 versus 55.6% in fiscal 2018, as customers require less on-premises maintenance and support. In our view, the products mix shift from hardware to software can raise gross margins to 85% in fiscal 2023 versus 83.3% in fiscal 2018. We model F5's revenue growth rate to outpace operating expenditures growth, and we foresee operating margin expanding to 32% in fiscal 2023 compared with 28.2% in fiscal 2018. In our model, R&D remains around 16%-17% of revenue, sales, and marketing slightly declines toward 29% of revenue by fiscal 2023, and G&A remains around 7% of sales.

Risk and Uncertainty 2019/03/08

We allocate F5 with a fair value uncertainty rating of medium. Although we opine that F5 was caught off guard with the growth in cloud-based workloads creating a lower demand for F5 hardware, our view is that the company's strategic pivot will keep it ensnarled in customer networks.

F5's competition now includes hyperscale cloud providers, like Amazon AWS, and open source ADC software-based solutions, in addition to the traditional ADC players like Citrix, Radware, and A10 Networks. The hyperscale cloud providers have the advantage of customers offloading workloads and data into their public cloud environments at a torrid pace as well as being the source of where many applications reside. As customers expand their networking presence, they could forgo on-premises solutions from F5, except for mission-critical on-premises traffic. In turn, F5 could be forced to rely on software and cloud-based sales, which could become price sensitive if F5 does not provides unique technological advantages versus lower priced open source or hyperscale cloud solutions. An additional threat is the large cloud providers creating solutions for intracloud and on-premises traffic.

In our view, a key aspect of F5's strategy is its technology alliances with leading cloud providers, networking firms, and security providers. Partners pushing their own solutions, in the case of cloud providers, or competing vendors instead of F5 would be detrimental and impact long-term growth opportunities. F5's reliance on value-added resellers and managed service partners creates a revenue concentration risk. At the end of 2018, Ingram Micro, Inc was 16.8%, Arrow ECS was 10.9%, and Westcon Group, Inc. was 11.3% of revenue. While F5 has traditionally showcased revenue concentration, we posit that being dropped from a line card or not properly incentivizing the resellers and partners to sell F5 solutions versus competitors could be drastic for the company.

Stewardship 2019/03/12

We assign a Standard stewardship of capital rating to F5. Francois Locoh-Donou became the CEO in April 2017 after John McAdam, CEO from 2000 to 2017, stepped down from the helm to pursue retirement. McAdam remains on the board of directors and helped choose Locoh-Donou. The new CEO's pedigree included leadership positions at Ciena, a networking solutions firm. Most of the executive team was revamped under Locoh-Donou's leadership, and F5 has pivoted its strategic focus to remain an ADC leader through software and cloud-based solutions.

The company's policy regarding cash has been to use it for business operations, acquisitions, and share repurchases. F5's $3.4 billion share repurchase plan was initiated in October 2010, and the company has expanded on its buyback scope annually. In fiscal 2018, F5 repurchased over $550 million worth of shares and the company announced an additional $1 billion authorized for share buybacks in January 2019. F5 has repurchased over $2.9 billion in shares between fiscal 2014 and fiscal 2018. F5 has never paid a dividend, and we do not expect a dividend in our forecast period. Most of F5's acquisitions have been modest in size until its acquisition of Nginx, the open source ADC provider, announced in March 2019 for $670 million. Other notable acquisitions are the security focused firms of Defense.Net for $49.4 million in 2014 and Verasafe for $87.7 million in 2013. We expect F5 to continually look for acquisition targets, possibly in the cloud traffic management and analytics space.

The CEO and other executives have their renumeration highly tied to longer-term incentives of the company. Compensation is correlated to revenue and EBITDA targets, and we find this structure sensible to ensure management does not grow the top line without aiming for a sustainable future for shareholders. As of January 2019, all F5 directors and executive officers own less than 1% of the outstanding stock.

F5 Networks is a market leader in the application delivery controller market. The company sells products for networking traffic, security, and policy management. Its products ensure applications are safely routed in efficient manners within on-premises data centers and across cloud environments. More than half of its revenue is based on providing services, and its three customer verticals are enterprises, service providers, and government entities. The Seattle-based firm was incorporated in 1996 and generates sales globally.